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Supply-side Economics

Supply-side Economics Supply-side economics is a branch of economics based on classical theory. Supply-side economics arose in the 1970s as an alternative to the dominant Keynesian economic theory. Supply-side economics emphasizes long run economic growth rather than short run economic stability. Supply-side economics argues that long run economic growth can best be achieved by maximizing the incentives that producers have to increase production. In other words, by encouraging the supply side of the economy. Supply-side Fiscal Policy versus Keynesian Fiscal Policy Keynesian fiscal policy theory emphasizes using fiscal policy to manipulate aggregate demand in order to achieve economic stability (full employment) in the short run. But supply-side economists assert that fiscal policy will also affect the supply side of the economy, both in the short run and in the long run. Supply-side economists argue that Keynesian fiscal policy has had a harmful effect on the supply side of the economy. Keynesian theory has made deficit spending politically acceptable. Since Keynesian theory was introduced, deficit spending has become the norm for fiscal policy. As mentioned earlier in the chapter, the federal government has had budgets deficits in all but 12 years since Keynesian theory was introduced. Deficit spending has led to a growing federal government. It is politically easier to increase government spending if taxes are not increased at the same time that the government spending is increased. Deficit spending makes this possible. Example 7A: In 1929 (before Keynesian theory made deficit spending politically acceptable), federal government expenditures were equal to about 2.5% of GDP. In recent decades, annual federal government expenditures have generally been about 20% of GDP. From 2009 through 2011, annual federal government expenditures were over 23% of GDP. Example 7B: In 1929, federal government expenditures were $3.1 billion. In 2014, federal government expenditures were $3,504.2 billion. After adjusting for inflation, federal government expenditures increased by over 80-fold. The growing federal government has led to higher marginal tax rates in order to finance (most) of the government spending. According to supply-side theory, high marginal tax rates have a harmful effect on the supply side of the economy, both in the short run and in the long run. High marginal tax rates reduce the incentive to earn higher income in the short run. Thus, high marginal tax rates will tend to reduce SRAS. High marginal tax rates also reduce the incentive to increase the productive capacity of one’s resources in the long run. Thus, high marginal tax rates will tend to reduce LRAS. High marginal tax rates will likely affect LRAS more than SRAS, as illustrated in Example 8 below. Example 8: If the top marginal income tax rate were increased from 39.6% (the rate in 2015) to 70% (where it was before the tax cuts of the 1980s), not very many surgeons, research scientists, software designers, etc. would give up their high income careers for something less demanding. But how many young people would decide that the sacrifice and cost of training to become a surgeon, research scientist, software designer, etc. was no longer worth the effort? The importance of incentives is discussed in an appendix at the end of this chapter. Supply-side economists support lowering marginal tax rates. Lower marginal tax rates will increase incentives to earn higher income in the short run and to increase the productive capacity of one’s resources in the long run. Thus, lower marginal tax rates will increase production in both the short run and the long run. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Fiscal Policy 9 - 6

The Laffer Curve What will happen to the government’s tax revenues if tax rates are reduced? The obvious answer would seem to be that lower tax rates will result in less tax revenue. But supply-side economists believe that the opposite may be true. Lower tax rates increase incentives and production. According to supply-side economist Arthur Laffer, the increase in production may increase the tax base (income) enough to more than offset the decrease in tax rates. Thus, lower tax rates may generate more tax revenue. The relationship between tax rates and tax revenue is illustrated on a Laffer curve. The Laffer curve indicates that lowering tax rates may increase tax revenue. Example 9: On the graph below, the tax revenue generated by a tax rate of 0% is $0. The tax revenue generated by a tax rate of 100% is also $0. At a tax rate of 100%, producers would have no incentive to produce. If the tax rate is high (point A on the graph), lowering the tax rate (to point B on the graph) would increase tax revenue. Tax Revenue Supply-side Tax Cuts $0 0% B A 100% Tax Rate Ronald Reagan became President in 1981. That same year, Congress enacted a supply-side tax cut, which lowered the top marginal tax rate from 70% to 50%. In 1986, the top marginal tax rate was lowered to 28%. Did these tax cuts reduce taxes paid by high income taxpayers? On the contrary, the taxes paid by the highest income taxpayers increased, while the taxes paid by most taxpayers stayed essentially the same. Overall, tax revenue increased after the tax cuts. Example 10A: In 1990, the top 1% of income earners paid 51% more federal income taxes (in real dollars) than they had paid in 1980. Likewise, the top 5% of income earners paid 36% more and the top 10% paid 28% more. The bottom 90% of income earners paid essentially the same in 1990 as they had in 1980. Example 10B: The percentage of income tax paid by the top 1% of income earners increased from 17.6% of federal personal income taxes in 1981 to 27.5% in 1988. The percentage paid by the top 10% of income earners increased from 48.0% in 1981 to 57.2% in 1988. The percentage paid by the bottom 50% of income earners decreased from 7.5% in 1981 to 5.7% in 1988. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 9 - 7 Fiscal Policy